DailyFinance.comhttp://www.dailyfinance.comDailyFinance.comhttp://o.aolcdn.com/os/df/2013/img/2-dailyfinance_logo_m.pngDailyFinance.comhttp://www.dailyfinance.comen-usCopyright 2015 Weblogs, Inc. The contents of this feed are available for non-commercial use only.Blogsmith http://www.blogsmith.com/Don't Believe the Hype About the "eBay of Latin America"http://www.dailyfinance.com/2011/07/29/dont-believe-the-hype-about-the-ebay-of-latin-america/http://www.dailyfinance.com/2011/07/29/dont-believe-the-hype-about-the-ebay-of-latin-america/http://www.dailyfinance.com/2011/07/29/dont-believe-the-hype-about-the-ebay-of-latin-america/#commentsFiled under: Company News, Stock Picks, Amazon.com

Investors have gone nuts for foreign stocks tied to social networking applications. Note:

The fanfare accompanying the introduction of Yandex (YNDX) -- the "Google of Russia,"

The incredible rise in Sina (SINA) -- the "Twitter of China" over the past six months.

And then there's the "eBay of Latin America" -- MercadoLibre (MELI). (Oh and let's not forget that MercadoPago, the company's payment transaction service, could become the "PayPal of Latin America.")

No doubt, the MercadoLibre bulls see this stock as a second chance to invest in eBay before it became the $40 billion e-commerce juggernaut that it is today. Not me.

At the right price, you could talk me into buying a soccer jersey from Brazil or even a used car from (gulp) Venezuela. But at $80, I wouldn't touch MercadoLibre with a 10-foot pole.

Hot Air and High Hopes

MercadoLibre has been a tremendous success story since its initial public offering in 2007. Annual sales have nearly tripled over the last three years, while profits have grown from less than $10 million to more than $60 million. It now runs online marketplaces in 12 countries, including Argentina, Brazil, and Mexico.

That type of growth and the thought of millions of new potential customers as a result of improving economic conditions and Internet connectivity have gotten investors giddy about MercadoLibre's potential. That's led to a nose-bleed valuation. At close to $80, Mercado trades for 15 times annual sales and nearly 50 times 2011 consensus earnings expectations -- more than three times what rival eBay (EBAY) currently commands.

The company is priced for perfection even without my concerns about its true performance. That makes it, in my opinion, a great shorting opportunity.

That said, shorting MercadoLibre over the past six months has been like sitting on a bunch of firecrackers being lit one by one. Just ask my portfolio. I'm down more than 15% on my MercadoLibre position since I decided to short it under $70. Painful. Yet, I'm confident in my short because think MercadoLibre's meteoric rise since mid-March was built on a lot of hot air.

Results Are Less Bubblicious Than They Seem

Mercado's move higher was timed almost perfectly with a sharp rise in the Brazilian real versus the U.S. dollar. This makes some sense because Mercado derives almost 57% of its revenue from Brazil (Argentina, Venezuela, and Mexico make up almost all of the rest), yet reports its results in U.S. dollars. Thus, a lower dollar and a higher real means more revenue for Mercado.

That being said, the company's first-quarter results weren't too shabby. Revenue of $61.5 million was up 44% over last year, and operating profits surged 50%. And gross merchandise volume, the dollar value of all transactions completed through MercadoLibre's marketplaces, grew 30% to $954 million.

But you have to appreciate just how much of an impact foreign currency changes had on Mercado's results. On a constant currency basis, Mercado's GMV grew a less-bubblicious 23% -- in Brazil, Mercado's largest market, GMV grew only 16% on that basis. The currency impact becomes even more apparent when you take into account that the exchange rate used by Mercado's Venezuelan subsidiary, which accounts for almost 10% of Mercado's revenue, was 23% higher against the dollar in the first quarter.

I'm not interested in shorting MercadoLibre as a play on a stronger dollar, but a sharp reversal in the Brazilian real and other Latin American currencies versus the dollar would certainly take a bite out of Mercado's operating results.

Digging further into Mercado's latest quarterly filing, I also note that the company continues to suffer in terms of earnings quality. Mercado's EBITDA (earnings before interest, taxes, depreciation and amortization) exceeded the company's operating cash flow in four of the last five quarters. That means the quarterly profits Mercado is reporting to investors aren't translating into the same level of cash flow, a strong sign of poor earnings quality. If you read my recent series on financial shenanigans, you'll know why you should always favor operating cash flow over reported earnings.

Back to That Inflated Price Tag

Ultimately, however, it comes down to price. I don't believe Mercado's results, while strong, justify a share price of $80 per share. At that price, investors are paying close to 15 times Mercado's annual sales, and more than 60 times annual free cash flow.

Compare that to Amazon.com (AMZN). It's a larger, more powerful company with a gigantic moat, and its 51% sales growth last quarter was actually much faster than MercadoLibre's 34% growth. Yet Amazon's shares trade for less than 3 times annual sales!

As for those who think this is an opportunity akin to investing in eBay in the beginning, be careful. The flaws I pointed out in Mercado's growth plans could cause investors to drastically dial back their expectations in the months to come. When that happens, MercadoLibre will come crashing down to a more realistic price, giving us the chance to profit by shorting today.

Cash is king. And unlike accounting inventions like "earnings per share" and "EBITDA," cash is tangible, fungible, and, heck, certain currencies are even smoke-able, I'm told.

Focusing on cash flow -- instead of the accrual based figures that Wall Street is so fond of -- is a good way for investors to measure a company's financial health and operational strength. That said, measuring a company's cash flow isn't as simple as calculating the difference between how many dollars leave a company's cash register and how many come in.

Just like with revenue and earnings, companies can use a whole range of tricks to manipulate cash flow and hoodwink investors. Savvy managers know that fancy verbiage and accounting sleight of hand can make even the poorest operating cash flow statement look like Warren Buffett's checking account.

Where's the Bacon?

The statement of cash flows is divided into three sections: operating, investing, and financing. Cash flows in and out of these sections depending on the type of activity. Here are some examples of typical inflows and outflows.

Section

Cash Inflow (+)

Cash Outflow (-)

Operating

Profits, receivables collections

Vendor payments, marketing costs, salaries, taxes

Investing

Plant/equipment sales, investment proceeds

Capital expenditures, asset purchases, acquisitions

Financing

Bank borrowings, stock issuance

Loan repayments, stock buybacks, dividend payments

Investors and analysts care most about the operating section of the cash flow statement, and for good reason. This is where the company makes its bacon. You want to see cash generated by the company's operations, not from unsustainable sources such as equipment sales and short-term investments, or from potentially troublesome sources such as borrowing and issuing stock.

Unfortunately, it's not always 100% clear where a company is generating most of its cash from. Here's how to tell whether your stock is cash flush or penny poor.

4 Signs a Company's Pulling a Cash Flow Hustle

1. Capitalizing Normal Operating Expenses: As discussed in the previous article in the series, companies will sometimes treat normal operating expenses as an asset, and shift them to the balance sheet to be amortized (depreciated) over many years. While this boosts profits, it also boosts operating cash flow, because normal expenses (operating cash outflows) get shifted to the investing section as capital expenditures (investing cash outflows).

Red Flag: On the cash flow statement, watch for an unusually large spike in capital expenditures, with a corresponding spike in cash generated from operations. If anything looks fishy, dig further.

2. Misclassifying Inventory Purchases: The costs to acquire or produce inventory that will be sold to customers should almost always be included on the operating section of the cash flow statement. But this isn't always the case.

Take Netflix (NFLX), which Howard Schilit discusses in his classic work, Financial Shenanigans. For years, Netflix has treated its purchase of DVDs -- the essential inventory of its business -- as an investing outflow, rather than an operating outflow. This is especially curious, because most of Netflix's new DVDs are amortized over a period of just one year. Netflix's accounting treatment provides a big boost for its operating cash flows. At the time it went bankrupt last year, competitor Blockbuster had been classifying its DVD purchases as operating outflows.

Red Flag: It's up to you to decide whether Netflix's inventory accounting is proper or not, but the basic takeaway here is that you should always question large investing outflows when they appear to be part of a company's normal cost of operations.

3. Serial Acquirers: Since 2008, industrial and agricultural conglomerate Trimble Navigation (TRMB) has made no less than 22 acquisitions. You might be surprised to learn that, despite all these acquisitions, and the nasty economic downturn, Trimble reported some of the highest operating cash flow results in its history from 2008 to 2010. How is that possible? Through the magic of acquisition accounting.

When one company acquires another, it uses cash (investing outflow) from its balance sheet, or cash from borrowing (financing inflow) or from issuing shares (financing inflow). The beauty here is that all the costs to make the acquisition come out of the investing and financing sections of the cash flow statement, but all the benefits -- increased sales and profits, acquired inventory or receivables that are then sold by the parent company -- are reflected in higher cash inflows on the operating section. Companies like Trimble that make regular acquisitions can repeatedly inflate their operating cash flows simply through the magic of acquisition accounting.

Savvy investors have a way of dispelling this. Trimble may have generated operating cash flow of $495 million from 2008 to 2010, but if you subtract Trimble's capital expenditures and the cash cost of acquisitions -- a measure of Trimble's free cash flow -- it's a much more pedestrian $139 million.

Red Flag: Watch out for companies that make numerous and routine acquisitions. Pay closer attention to free cash flow (operating cash flow less capital expenditures and acquisition costs) to measure the strength of a company's operations.

4. For the Love of EBITDA: Lots of investors come across the term "EBITDA" without knowing what it means. EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is a trendy accounting invention that corporate managers like to use as a proxy for their company's operating cash flow. By removing interest and taxes (which are non-operational costs) and depreciation and amortization (which are noncash accrual expenses), managers think they're presenting an appropriate and measurable metric of their company's operational prowess.

My word for EBITDA: fugetaboutit!

Interest and taxes are real cash expenses that should be accounted for. By excluding interest in particular, serial acquirers like Trimble can run up their debt to dangerous levels to acquire a bunch of bad businesses. Their EBITDA might look beautiful in the short term, but the debt and interest payments could eventually sink them. Most worryingly, EBITDA excludes changes to working capital accounts like accounts receivable and inventory, which have real cash impacts on the business.

Red Flag: Avoid companies that like to use EBITDA as a measure of their company's performance, especially if it's tied to management's compensation incentives. Stick to operating cash flow and free cash flow.
More ways to spot financial shenanigans before they bring down your portfolio:

Motley Fool senior analyst Matthew Argersinger does not own shares of any of the stocks mentioned in this article. You can click here to see his holdings and a short bio. Motley Fool newsletter services have recommended buying shares of and put options on Netflix as well as shorting Trimble Navigation.

(Financial shenanigans cost shareholders billions of dollars. This is part of an ongoing series about how to spot Wall Street wrongdoing before it puts your portfolio in jeopardy. See last week's "Is There an Enron Sitting In Your Portfolio?" for more.)

For many companies, meeting or beating quarterly earnings estimates matters more than anything else. Add stock options to the mix, or big cash bonuses tied to short-term earnings or stock price targets, and executives' temptation to focus exclusively on quarterly results becomes irresistible. In the worst cases, this tunnel vision can drive companies to creative accounting, or even fraud.

Consider these shameless words from former CEO Joe Nacchio in January 2001, months before his company, Qwest Communications, began a precipitous decline that took its stock from the mid-$30s to a low of less than $2 by August 2002:

The most important thing we do is meet our numbers. It's more important than any individual product; it's more important than any individual philosophy; it's more important than any individual cultural change we're making. We stop everything else when we don't make the numbers.

Congratulations, Mr. Nacchio! Qwest may have made its numbers, but it did so via methods that eventually cost shareholders billions.

Qwest ultimately restated its earnings, increasing its losses in 2000 and 2001 by more than $2 billion. Nacchio resigned in June 2002; he was later convicted of insider trading and carted off to jail.

Unfortunately, what happened at Qwest isn't all that uncommon.

Why Earnings Are So Easy to Manipulate

Bad companies always ultimately lose the expectations game. Accounting trickery can only cloud a company's struggling operations for so long. Astute investors can look behind the numbers and spot the red flags that clue us in when a company's earnings results aren't worth the paper they're printed on.

Earnings are at the very bottom of the income statement (hence the term "bottom line"). They're the end result after all expenses -- raw material costs, salaries, marketing expenses, research and development, interest, and taxes -- are taken out of revenue. Unfortunately, that also makes earnings the figure most susceptible to manipulation.

Shift some expenses around, draw down some reserves, play with your tax rate a bit, and presto! That quarterly earnings per share (EPS) result suddenly goes from a miss to a beat. Hey, what's a penny or two between friends, if it leads to that fat year-end bonus and a higher stock price?

4 Signs of Earnings Funny Business

Howard Schilit, founder and CEO of the Financial Shenanigans Detection Group, has written extensively on the subject of earnings shenanigans. Here are a few of the major earnings red flags he discusses in his book, Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. According to Schilit, these signs may indicate that a company is trying to pull a fast one:

1. Smooth and predictable EPS
Wall Street loves steady earnings results, and that's what many managers strive for. But companies that consistently meet or exceed Wall Street's consensus earnings estimates are often gaming their company's earnings to do so. Be especially wary of managers who publicly tout their earnings-guidance track record. At the very least, it illustrates the short-term approach they're taking with the business.

2. Boosting income or lowering expenses using one-time events
You might be used to seeing management make statements-of-issues releases with words like "adjusted earnings" or "earnings before one-time charges or expenses." Companies will periodically experience one-time or non-recurring changes to their business: perhaps the sale of a factory, a large gain on an investment, a charge to restructure the business, or a large write-off of obsolete inventory.

Your job is to figure out when management is making appropriate adjustments to the income statement, and when it's inappropriately shifting line-items around to simply paint a prettier picture of the business. The difference between right and wrong lies in how companies classify these one-time events, and where they show up on the income statement. For example:

Some companies will include one-time gains from asset sales or investments in the operating section of the income statement, as a way to boost operating profits. Obviously, if these activities aren't normally part of the ongoing operations of the business, they shouldn't be there.

On the other hand, restructuring charges, which aren't normally included in operating expenses, should be there if the company keeps reporting regular restructuring expenses. You could call these "recurring nonrecurring" charges.

Finally, a large write-off of bad inventory or uncollectible debt should also be included in operating expenses. Often, it's not.

3. Inappropriately capitalizing normal operating expenses
One of the classic ways companies boost short-term earnings involves capitalizing certain expenses that should normally be included on the income statement. In essence, a company treats normal operating expenses as an asset, shifting them to the balance sheet to be amortized (depreciated) over many years, instead of in the current quarter.

WorldCom, the famously bankrupt telecommunications giant, reported billions in inappropriate profit by capitalizing a significant portion of its line costs -- the fees WorldCom paid to other telecom companies to access their networks, a perfectly normal part of its everyday business.

Watch for big increases in capital expenditures on the cash flow statement, with corresponding reductions in operating expenses on the income statement. That might give you a clue that a company is suddenly shifting normal operating expenses to its balance sheet.

4. Unusual changes in reserve accounts
Computer and car manufacturers normally bundle warranty plans with their products. These plans cover any potential problems you might experience, with the promise to fix or replace any defects over a predetermined number of years.

Manufacturers are required to record an expense and a liability reserve on the balance sheet for expected future warranty costs at the time the product is sold. Similarly, most companies set aside reserves to cover a portion of their accounts receivable -- the amount their customers owe them -- that they don't think they'll collect. And banks, when they have to, set aside certain amounts to cover expected loan defaults.

But management can exercise considerable discretion about how much money to mark for future liabilities. Reserve too little, and profit margins get a nice short-term boost, at the risk of higher expenses -- not to mention lower profits -- down the road.

In 2007, computer maker Dell (DELL) was required to restate its earnings for several years, because it improperly accounted for warranty liabilities. Investors should monitor changes in reserve items relative to revenue. If reserves decline relative to revenue, it could signal that a company is inflating earnings by not properly accounting for future costs.
Next in this series, we'll help you spot cash flow red flags.

Motley Fool senior analyst Matthew Argersinger does not own shares of any of the stocks mentioned in this article. You can click here to see his holdings and a short bio.

Ask most investors -- even financial experts -- to explain what happened to Enron and they'll bring up those bizarrely named fake partnerships the company used to hide massive amounts of its debt.

The faux off-balance-sheet partnerships that Enron employees named after Star Wars characters and themes -- the Joint Energy Development Investment (abbreviated as JEDI), Kenobe Inc., Obi-1 Holdings and, of course, Chewco Investments -- would be funny if they weren't merely a sideshow compared with the monumental financial shenanigans taking place at the company.

Granted, silly names aren't a typical sign that there's something rotten with the state of a business. However, when a company's revenues surge from less than $10 billion to $100 billion in five years -- as Enron's did from 1995 to 2000 -- it's time to put down the champagne and start asking questions. After all, consider that the average company that's attained the $100 billion threshold (and there have only been a handful) took 25 years to hit that mark.

What was behind Enron's unbelievable growth

How did Enron pull the wool over so many investors' eyes? In business-speak, the company used some slick sleight-of-hand to change its revenue recognition policy to treat its boring utility business (which sold future delivery of natural gas) as a financial securities business. Using mark-to-market accounting (stay with me here), it treated its service contracts as tradable securities and booked the entire expected revenue from its service contracts immediately, instead of over the life of the contract.

Worse still, there were no actual markets (e.g., no actual customers) for many of the contracts Enron was supposedly selling.

Ultimately, Enron couldn't keep up with the fancy results it was reporting to investors -- later dubbed its "mark-to-make-believe" model -- and it ended in disaster for all of the investors that had been seduced by its unprecedented and fraudulent revenue growth.

Sponsored Links

Oh, but Enron's Not the Only Bad Apple

Enron may be one of the more infamous, but it's just one of many examples of financial chicanery in recent corporate history -- Computer Associates, MicroStrategy, Satyam, and WorldCom are all once highly respected names that seared legions of investors.

More recently, Bank of America (BAC) agreed to an $8.5 billion settlement for its role in perpetuating mortgage fraud during the housing boom. Its stock price is still down some 80% from its 2007 high. And it doesn't seem like a week goes by without hearing of yet another U.S.-listed Chinese company being accused of some form of corporate malfeasance.

Examples of financial shenanigans are rich, ripe, and recurring. Learning to spot potential financial black holes -- which we'll help you do in this series -- will help you avoid bad investments and purge your portfolio of ticking time bombs.

Is your company monkeying with revenue reporting?

Investors usually don't think of a company's revenue as a likely source of financial shenanigans. Maybe that's why it's a popular hiding place for ne'er-do-wells to manipulate their results to meet or beat quarterly expectations. After all, investors assume that with revenue, it's what you see is what you get, right?

Not necessarily. With top-line revenue, it's all about recognition of that revenue. When demand starts to slow, aggressive management teams accelerate revenue recognition to give the appearance that customer demand is still strong. For example, a company may extend payment terms to customers who agree to make a purchase today instead of at a planned later date. Or it might begin to book revenue from a software license, even though the product hasn't been delivered to the customer yet.

By pulling revenue forward from future quarters -- money that hasn't yet been made -- companies are, in effect, stealing from their future to pretty up the present.

The problem with pushing revenues around is that recognizing them early dramatically increases the risk of an earnings miss down the road. The downward spiral can get ugly: We've all had the experience of watching one of our stocks plummet after it misses estimates.

6 signs of accelerated revenue recognition

Here are some red flags to watch for so you don't get dragged down by a company engaging in accelerated revenue recognition:

Red Flag

What It Tells You

How To Spot It

Receivables growing faster than sales

Accounts receivable measure how much cash a company is owed from customers. If receivables grow faster than sales, the company could be extending generous terms to entice more orders, or it could be having difficulty collecting the money it's owed.

Using the income statement and balance sheet, watch for trends in revenue and receivables growth. Ideally, you want receivables to grow at the same rate of or below sales.

Increase in days sales outstanding, or DSO

DSO measures the number of days in a quarter that it takes for a company to collect on its bills. Related to our receivables analysis above, a higher DSO is an indication of aggressive revenue recognition, poor cash management, or both.

To calculate DSO, divide a company's ending receivables with its revenue and multiply the result by the number of days in the period (e.g., 91.25 days for a quarter).

Use of percentage of completion, or POC, accounting

Under POC accounting, a company recognizes revenue on long-term contracts in proportion to the work completed, even though customers may have yet to be billed. Management could overestimate work completed and prematurely boost revenue.

Check a company's 10-K under revenue recognition policy and see if they are using POC accounting. Also watch for any sharp increases in unbilled receivables relative to revenue.

Big drop in deferred revenue

Software and subscription-based companies often receive cash in advance of delivering a product or service. A sharp drop in deferred revenue boosts revenue in the short term at the expense of future quarters.

Check a company's balance sheet and watch for any unusually large drops in deferred revenue.

Including inappropriate items in revenue

Proceeds from asset sales, investment gains, and interest on cash usually shouldn't be counted in revenue and can give a false sense of a company's operational strength.

Check the latest 10-Q or 10-K to see if any of these line items are being included in revenue. If so, remove them and reevaluate the company's revenue growth.

A change in revenue recognition policy.

Anytime a company changes the method or timing of its revenue recognition, alarm bells should be going off. What is the motive?

Check the most recent 10-K under revenue recognition policy for any mention of changes to methodology.

Next in this series, we'll help you spot earnings and cash flow red flags.

Motley Fool senior analyst Matthew Argersinger does not own shares of any of the stocks mentioned in this article. You can click here to see his holdings and a short bio. The Motley Fool owns shares of and has opened a short position on Bank of America.